Bid Offer Dark Pools – a Free Lunch?

White Paper WP0003

Short Article(7 pages)

Background

Until a couple of years ago, all executions on MTF Dark Pools in Europe were matched
using the mid price of the primary lit market.

More recently, some MTF Dark Pools have begun to offer the option of matching orders
based on Primary or EBBO touch prices rather than mid prices. In these new pools,
incoming aggressive buy orders are matched with a resting sell order at the offer
price of the lit market.

We will refer to pools offering such matching as 'BBO Dark Pools' and at the time
of writing, Dark Pools offering BBO Matching include SIGMA X MTF, UBS MTF and Instinet
BlockMatch.

The benefits for the passive side of executing a dark trade in a BBO Dark Pool as
opposed to matching at mid price are fairly obvious. Rather than splitting the spread
with the aggressive side of the trade, as they would in a pure mid-point Dark Pool,
the passive order will capture the 'whole spread' as recompense for providing liquidity,
i.e. the same reward they would get for providing liquidity in a lit venue but without
needing to 'show' the size of their resting order.

But how about the aggressor? Clearly it would be better for the aggressor, wherever
possible, to get a mid-price match on a mid-point matching Dark Pool if that option
is available. But if that option has been tried and there is currently no resting
liquidity on any Dark Pools for a mid-price match, and the trade must be done now,
then the two principal remaining options are:

sending their order to try to match at bid/offer touch price on a BBO Dark Pool
or

sending it to a lit venue.

Which is the better option?

Advantages and Disadvantages of BBO Dark Pools

Let's consider the pros and cons of sending an aggressive order to a BBO
Dark Pool or to a lit venue.

Execution Certainty - By making the provision of liquidity more attractive
for the passive side of the order, a BBO Dark Pool is likely to encourage more liquidity
to be provided more consistently than a pure mid price matching dark pool and therefore
is likely to offer a better overall probability of getting a match. However, by
definition, and ignoring latency effects, a lit venue offers (almost) certain execution
at the displayed price so without any other advantages it would be unusual to take
the less certain option of sending an order for a possible match in a BBO Dark Pool
when a lit match at the same price is available.

Exchange Fees - The exchange fees for the aggressor matching on BBO
Dark Pools are currently quite a bit lower than the fees of sending aggressive orders
to lit venues (including the lit MTFs). So, as long as the same execution price
is achieved (which should be the case) then the total cost of an order will be cheaper
when using the BBO Dark Pools.

Market Impact - An advantage to the aggressor
of a traditional mid price matching dark pool trade is that, in theory, the mid
price match will mask the side (buyer/seller) of the aggressor and so will lead
to much lower (possibly zero) market price impact¹. However, in
the case of a touch price match on a BBO Dark Pool, the side of the aggressor is
clear to anyone watching the trade tape and so market participants providing liquidity
in lit markets might see these aggressive buy/sell trades occurring on BBO Dark
Pools and adjust their quotes in lit markets, causing price impact. So, there is
likely to be some market impact when executing aggressively on a bid/offer pool,
but intuitively it might be less than sending the equivalent order to a lit venue.

Size improvement. Most BBO Dark Pools will match at touch bid/offer
prices regardless of the size being traded. So it is possible that an order matched
at touch price on a BBO Dark Pool will actually provide the aggressor a fill with
more volume than could be matched on lit i.e. without having to match 'down
the book at worse prices'. Where this happens, this is an effective price improvement
for the aggressor.

The first two points are fairly clear and un-contentious. Execution certainty is,
almost by definition, more uncertain when sending an order to a Dark Pool and exchange
fees are definitely lower on Dark Pools (at least at the time of writing).

The potential benefits of the latter two points (reduced market impact, size improvement)
might be true but really need to be tested in order to quantify any benefit they
yield in practice. In the rest of this article, we will test this theory.

¹
In fact, because most
mid matches happen at primary mid rather than EBBO mid and the fact that some algos
will take advantage (directly or indirectly) of small arbitrages between PBBO and
EBBO by sending aggressive orders to the dark pools, there is still typically a
small observed price impact in the direction of the aggressor. We have previously
shown this in our article 'Can you hide in the Dark?’

1. The Sample Sets Used In This Study

To test the theory that market impact is lower when aggressively
executing on BBO Dark Pools compared with lit markets, we have extracted a set of
aggressive trades sent by a single Agency Broker (Neonet) over a month. The trades
are all in Swedish stocks and were sent to a mixture of:

In order to make sure that we compare like with like
we have sub-selected trades of similar sizes, namely SEK 10,000 to SEK 100,000.
Within this set, the average trade sizes and the types of stocks traded were similar
across execution venues in terms of on-book spreads. So although there may be some
bias in the types of trades executed on the different venues, we think it is unlikely
to affect the general results we report.

For the second part of the study, looking at whether
there is a size improvement relating to aggressive trades on BBO Dark Pools, we
take the full set of all European trades of all sizes executed by Neonet over the
same month.

The table below summarises the fees applicable for aggressive
orders sent to the four venues (correct as of January 2013).

Many market participants would assume that sending an aggressive order to a dark
BBO Dark Pool might have less market impact than sending the same order
to a lit venue. Intuitively this makes sense, but is it actually true and if so
can we quantify the difference?

The graph above shows the results of testing this theory on our sample set of trades.

To quantify market impact, we look at the evolution of EBBO mid prices in a window
1 second before and up to 5 minutes after each aggressive execution. Within the
5 minute window, we measure the amount of market impact (increase in EBBO mid price
following an aggressive buy or decrease in EBBO mid price following an aggressive
sell) at various time points. We then average these impacts over all trades in the
set.

The results are fairly striking. The graphs show the average EBBO market impact
in BPS at various times after a trade. As would be expected for aggressive trades,
the results show positive market impact for all 4 venues.

However, the market impact in the
first 50-100 milliseconds after an execution is much lower for the two BBO Dark
Pools than for the two lit markets; in fact almost an order of magnitude lower.
This is perhaps not so surprising. By sending an order that removes liquidity to
a lit market, we will by definition instantly affect EBBO, which is based on
that same lit liquidity.

More significant than the high frequency EBBO price movements immediately following
a trade is the fact that if we look a full 1 minute after the trades, the impact
on EBBO mid price of the lit trades remains about 2-3 times higher than the impact
of aggressive trade on the BBO Dark Pools.

So the (semi) permanent impact of a trade on a BBO Dark
Pool is 2-3 times less than a lit trade.

3. Size Improvement on BBO Dark Pools

As well as lower market price impacts shown in the previous section, another potential
benefit to the aggressor of trades executed on a BBO Dark Pool is the so called
'size improvement'.

This is due to the fact that the matched price on a BBO Dark Pool is always the
touch price even if the volume matched on the BBO Dark Pool is larger
than the volume available on any lit venue.

To quantify this we do the following:

Firstly, we take each EBBO Dark Pool trade (this time of all size trades, not just
those between SEK 10,000 - SEK 100,000) and simulate sending a single aggressive
order of the same size, side and timestamp to each lit venue (XSTO,CHIX,BATE,TRQX,BURG)
at the time of the EBBO Dark Pool trade.

Where there is insufficient volume to fully execute the simulated aggressive order
at the best price on a given lit venue, we match down the order book and determine
the average volume weighted price that would be obtained by matching the full volume
("effective price"). We collate the simulated effective prices obtained
in this way for all venues and then select the venue with the 'best' price.
This represents the best price that could have been obtained by sending a single
aggressive order to execute on any one lit venue.

We compare this best lit effective price with the price actually obtained in the
Dark Pool. We then quantify the number of times the dark pool price was better than
the best lit effective price and also the average improvement (in BPS) over all
of the BBO Dark Pool executions.

The table below shows how often the trades on the BBO Dark Pools execute at prices
better than the best lit effective price and also quantifies this improvement in
BPS averaged over all flow sent to that Dark Venue.

Number Of Dark Bid/Offer Trades

% Trades With more Volume than EBBO

BPS Improvement due to extra size

15,248

3.84%

0.19 BPS

About 3.8% of the time the BBO Dark Pool trade is for a volume greater than that
available at touch on any 1 lit venue and the benefit of this equates to about 0.19BPS
when averaged over all 15,248 trades executed on the Dark Pools.

Conclusions

The two empirical facts we have shown in this study
are:

Market price impact is considerably lower when sending an
aggressive order to a BBO Dark Pool than when sending an aggressive order
to a lit venue.

Around 3-4% of the time, the trades sent to a BBO Dark Pool by Neonet could not
have been fully executed on a single lit venue at EBBO price. This 'size improvement'
corresponds to an improvement in price of about 0.2BPS when using
BBO Dark Pools.

As exchange trading fees are also currently lower when sending orders to BBO Dark
Pools, it would seem that in all cases, from the point of view of the aggressor
looking for additional liquidity, an execution on a BBO Dark Pool is preferable
to a similar execution on a lit venue in that it will lead to lower costs, less
market impact and potential price improvement due to the size of the orders that
might execute.

Given this, it would seem that growth in these types of pool in the near future
is quite likely.

There are two caveats to this:

As we said at the beginning of the article, the one key drawback to the aggressor
when using a BBO Dark Pool is that execution is less certain than executing on a
lit venue. So, the advantages of executing on a BBO Dark Pool must be balanced against
the time spent sending an IOC to a BBO Dark Pool and the probability of non-execution.

So far we have considered purely the interests of the participants in the BBO Dark
Pools. If we take this to its logical conclusion and say that all aggressive trades
should be sent first to BBO Dark Pools, and if there was significant liquidity posted
on the BBO Dark Pools (such that executions occur there), then ultimately price
formation on lit markets would suffer. Why would a market participant post liquidity
on a lit venue when the 'front of the queue' is always effectively the liquidity
resting on the dark pool?

As exchange trading fees are also currently lower when sending orders to BBO Dark
Pools, it would seem that in all cases, from the point of view of the aggressor
looking for additional liquidity, an execution on a BBO Dark Pool is preferable
to a similar execution on a lit venue in that it will lead to lower costs, less
market impact and potential price improvement due to the size of the orders that
might execute.

Disclaimer

The information contained within this website is provided for information purposes only. IFS will use reasonable care to ensure the accuracy of the information within this site. However, IFS will not be held liable for any errors in the information provided within this website or for accuracy or completeness of the information, or for delays, interruptions or omissions therein, any difficulties in receiving or accessing the website and/or for any loss direct or indirect (including without limitation, loss of profits or consequential loss and indirect, special or consequential damages) howsoever arising and whether or not caused by the negligence of IFS, its employees or agents. The information contained within this site may be changed by IFS at any time.

The information available within this website may include ‘Evaluations’ which are not reflections of the transaction prices at which any securities can be purchased or sold in the market but are mathematically derived approximations of estimated values. Nevertheless, reference may sometimes be made to Evaluations as pricing information, solely for convenience or reference. Evaluations are based upon certain market assumptions and evaluation methodologies reflected in proprietary algorithms and may not conform to trading prices or information available from third parties. No liability or responsibility is accepted (and all such liability is hereby excluded) for any information or ‘Evaluations’.

The copyright of this website and all its content belongs to IFS. All other intellectual property rights are reserved. Redistribution or reproduction of the information and data contained within this website is prohibited without the prior written permission by IFS.